As the last half decade has shown biotechnology investments can be a very rewarding allocation. However, there are a number of ways to gain exposure to the biotech space, all of which come with varying risk reward profiles. An investor’s personal risk tolerance will generally dictate his or her allocations, with the more risk tolerant investor likely to weight a portfolio towards the potential for gains, and more risk averse investor likely to the opposite. The great thing about the biotech space is that this weighting is relatively simple to put into practice, as the sector is broken into clearly defined subsectors, each of which commands its own risk profile. So, with this said, here is how to set up your portfolio according to your personal risk tolerance. First then, let’s look at the different types of broad exposure.

Big Pharma

Across the entire biotechnology and pharmaceutical space, there are probably six or seven mega cap incumbents that make up the group you will commonly hear referred to in popular news media as Big Pharma. Companies like Gilead Sciences Inc. (NASDAQ:GILD), Amgen Inc. (NASDAQ:AMGN) and Celgene Corporation (NASDAQ:CELG) are worth hundreds of billions of dollars, and dominate the space as a result. You can think of these as the blue-chip companies of the sector, and as such, they are very low risk allocations. However, as always, this low risk has associated with it low reward. Why? Because in biotech, FDA approvals drive market valuation. Perhaps more specifically, the implications of an FDA approval on the bottom line of the company involved drive market valuation. If a microcap company gets a blockbuster (circa $1 billion) treatment approved, it is likely to have a massive impact on that company’s revenues. For a company worth hundreds of billions of dollars already, however, not so much.

Large Cap

Outside of these mega capitalization companies, you’ve got a range of large cap stocks that generate substantial revenues, and can also offer relatively low risk exposure to the biotech space. Such companies include BioMarin Pharmaceutical Inc. (NASDAQ:BMRN) and Incyte Corporation (NASDAQ:INCY). These types of companies have a market capitalization of anywhere above $10 billion, and regularly generate revenues in the hundreds of millions of dollars range. The great thing about this sector is that the size of the companies make them relatively low risk, but they also often make attractive acquisition targets for the mega caps mentioned above. Since acquisitions generally come at a premium to market price, a successful buyout can quickly offer substantial returns on an exposure.

Mid Cap

Mid cap biotech’s generally range from the $1 billion mark to the $10 billion mark valuation. Anacor Pharmaceuticals, Inc. (NASDAQ:ANAC) is a perfect example of this type of stock. They will often run at an operational loss, and have one or two approved treatments generating in the low tens of millions of dollars revenues annually. The reason most of them run at a loss is rooted in the capital expenditure associated with their ongoing development pipelines, and in these pipelines there can be substantial upside on successful approval. Mid caps are risky, generally because they require funding (often through partnerships with bigger companies) in order to maintain operations. However, some of the risk is mitigated by the fact that – as mentioned – they have products already generating revenues at market.

Small Cap

Finally, small caps. Anything with a valuation below say $250 million is probably not worth considering, so small cap sits between around the $300 million and the $1 billion market capitalization brackey. Small caps usually won’t have an FDA approved drug on their roster, and as such, won’t be generating any revenues. You may see revenues reported on submitted financials, but these generally can be attributed to research grants and cooperative milestone payments. These types of biotech companies are, of course, the most risky. The path to FDA approval is long and costly, and the vast majority of treatments fail. However, on the flipside, this risk for some investors is outweighed by the potential for huge upside gains. Clinical trial data, partnership agreements and FDA designation updates drive the valuation of these stocks, so expect volatility along the way.

Your Biotech Portfolio

How you combine these different types of increase to form a portfolio is up to you, and as we have said, will be highly dependent on your risk tolerance. However, as a guideline, a risk averse investor could allocate 75% of their biotech portfolio to large capitalization and mega capitalization companies, 15% to mid-sized biotech’s and the final 10% to a promising group of small cap stocks. An investor with a high risk tolerance, on the other hand, may want to forego some of the safety of a 75% large cap allocation in order to expand their exposure to the upside potential of mid and, in particular, small caps.